This problem shows the importance of considering the importance of converting operating leases to capital leases for the purpose of financial statement analysis. It is based upon the techniques developed and illustrated in Imhoff, Lipe, and Wright (1991 and 1997) though it is much simplified from their presentation.
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Required:
a. Convert the operating lease to a capital lease which is 1 year old. Assume that straight-line depreciation is used for both book and tax purposes. There would be a zero salvage value.
b. Determine the net income after taxes if the leases are treated as capital leases.
c. Determine the return on assets under the
(a) Operating lease assumption and
(b) Capital lease assumption.
d. Determine the debt-equity ratio under the
(a) Operating lease assumption and
(b) Capital lease assumption.
e. Do you think it is useful to convert operating leases to capital leases for financial statement analysis purposes? Discuss.